What is GDP and its importance in Forex Trading
Fundamental Analysis is one of the best ways we can use to approach the markets.
A lack of the fundamentals is a key reason why so many retail traders never trade consistently. Many traders don’t pay any attention to the real reasons why prices are moving.
They stare at their charts and hope their technical strategy will work. Approaching the markets with pure charts is dangerous. There is a much better way to do things.
The is why Fundamental analysis is so essential. It allows traders to understand WHY currencies are moving.
One of the most significant parts of Fundamental analysis is following Economic Indicators. In this article, we will discuss a significant indicator called Gross Domestic Product.
Or GDP for short.
The basics of Fundamental Analysis
Economic Indicators like GDP are essential tools for keeping track of the markets. Investors use these indicators to evaluate the overall health of various economic sectors.
Bad economic data usually points to a slowing economy. Whereas good economic data usually indicates a growing economy.
Economic Indicators can drastically change expectations in the markets.
When an economy is expected to grow, there is more demand for its currency. If an economy is expected to slow, there is less demand for its currency.
Currency prices are driven by supply and demand dynamics. Supply and demand is heavily influenced by expectations in the markets.
Are economic indicators always important
Are there specific economic indicators that have more impact than others?
The answer is yes, and the reason for this is monetary policy. Monetary policy is the management of a country’s money supply.
This task is performed by the central bank of a country. Interest rates are one of the key tools used by Central banks.
They rise or lower interest rates to control the supply of money in the economy. Interest rates are a critical influencer of currency values.
Higher interest rates usually cause an appreciation in a currency. Falling interest rates typically lead to a depreciation in a currency.
Central banks carefully study economic indicators like GDP. They use them to determine when an economy needs to adjust interest rates.
The impact of economic indicators depends on their possible effect on interest rates.
Economic growth is an essential data point used by central banks.
What is Economic Growth
Economic growth is the rate at which an economy expands.
Have you noticed a lot of construction work? Have you seen new companies opening?
These are all signs of economic expansion.
When an economy is growing, we call that expansion. If an economy is not growing, we call that contraction.
Inflation occurs when the average prices for things go up over time.
What does it mean when someone says economic growth is 3% this year? It basically means the economy has expanded 3% this year compared to last year.
Economic growth causes the standards of living to rise. This happens because a growing economy provides more jobs.
When more people have jobs, it means more people can spend money. As more people spend more money the economy grows even more etc.
What is GDP
GDP is short for Gross Domestic Product. It is one of the most widely used measures of economic growth.
The GDP measures total goods and services produced from one period to another. It tracks the total production of an economy.
GDP year over year measures the total production for an economy from one year to another.
CPI month over month tracks the total production for an economy from one month to another.
What type of things are measured as part of GDP?
- Total Investment (all investment in housing, inventories and equipment)
- Private Consumption (all private spending by consumers)
- Net Exports (the total net exports after imports are deducted)
- Government Spending (all government expenditures from salaries to infrastructure etc.)
Two types of GDP
There are two different types of GDP readings that are important to differentiate.
These two are known as Headline GDP and Real GDP.
Headline GDP is the standard measure of growth. This measure can be very volatile from one period to another.
If prices change drastically from one year to another, it will affect headline GDP.
Production costs might be higher in one year due to things like labour strikes. Energy prices might be inflated in a previous year due to a war in the middle east.
These are just a few examples of how GDP can be impacted by inflation.
For a more accurate measure of economic growth, we look at Real GDP. Real GDP is inflation-adjusted GDP.
It tracks economic growth by taking an average price over two periods. That way it’s possible to measure whether production was truly higher or lower.
Central banks usually focus on Real GDP as it strips out possible noise.
Economic growth might not always be good
This all depends on where an economy is in the business cycle.
Every economy will go through business cycles. The commonly known cycles are recessions and expansions.
Economic growth can be good or bad depending on the current economic cycle.
An economy that is at the peak of an expansion phase is expected to have higher growth. Economies that are in a recession usually has lower growth.
For the most part, central banks prefer to keep growth in a sustainable range.
Stable growth is more important for central banks. There are cases where growth can get out of hand in an economy.
In such scenario’s economies can run the risk of overheating. In other words, too much growth is not a good thing.
For this reason, central banks prefer stable and sustainable growth.
GDP and Interest Rates go hand in hand
We’ve learnt that Central banks are responsible for adjusting interest rates.
If an economy needs growth, the central bank may cut interest rates. When an economy is overheating a central bank may raise interest rates.
Interest rates have a significant impact on the economy. Especially on the value of its currency as well. Growth (GDP) is an essential indicator for central banks.
They use it to gauge economic growth and decide on the best course for monetary policy.
Most central banks have specific targets where they want growth to be. They will adjust interest rates to keep growth as close to their goal as possible.
How will lowering interest rates affect growth?
Lower interest rate means borrowing costs are low. As a result, companies and consumers will borrow more freely.
This causes companies to borrow money to expand and grow. When companies expand and grow, they require more workers.
Consequently, employment starts to rise. When more people have work more people can spend money in the economy.
As spending increase, it causes more demand for goods and services. As a result, companies expand even more to deliver on the growing demand.
This was a basic example of how lower interest rates affect growth in an economy.
How raising interest rates will affect growth?
Higher interest rates mean borrowing costs are high as well. As a result, companies and consumers don’t want to borrow money.
This causes a fall in business growth as companies don’t want to borrow money to expand. As borrowing slows and companies stop growing the economy starts to contract.
The slowing economy means companies start losing money. They lose money as demand for their products decrease, and their labour costs are high.
As a result, companies start to cut back on staff. Unemployment begins to increase.
In turn, this leads to fewer people that have jobs and fewer people who have money to spend.
This cycle continues downwards until the economy’s growth contracts. This is commonly known as a recession.
Why GDP data is essential in Forex Trading
Expectations are a vital driver of the supply and demand of currencies.
A currency’s demand usually increases when markets expect interest rates will rise. Similarly, demand falls if they expect a central bank to cut rates.
Growth (GDP) data can help traders anticipate when central banks might adjust rates.
When growth is too low markets will expect interest rate cuts. If growth is too high, then traders will anticipate potential interest rate hikes.
When the expectations for rates change it can provide excellent trading opportunities.
How to use GDP data in Forex Trading
Firstly, you need to do research and see where the growth numbers are for an economy. You will be able to find this info with a quick google search.
Secondly, analyse what type of rate cycle the central bank is currently in. For example, is the central bank presently hiking, holding or cutting rates.
Big moves often occur when growth numbers cause markets to change their expectations.
To demonstrate, imagine that markets are expecting higher rates for an economy. However, the GDP numbers start to slow significantly.
This will eventually start to change the market’s interest rate expectations.
Thirdly, you need to find an economic calendar. Then, find out when GDP releases are due to occur.
Make sure to evaluate how markets react to the event on its release. Read comments from market analysts before and after the event.
This will give you a good idea on how to approach these events.
In this article, we learnt what GDP is and why it’s essential for economies and trading.
We also saw why GDP has such a significant impact in Forex Markets. Finally, we also discussed how we can use CPI releases to our advantage.
Practice is the best way to get into tracking and trading with economic data. There are no shortcuts when it comes to trading.
Feel free to leave us any comments or questions below.